Fortinet, Inc. — Q3 2012 Form 10-Q
Reporting period: Quarter and nine months ended September 30, 2012. Unaudited results are compared with the corresponding 2011 periods. Fortinet provides network security appliances, software, subscriptions and support services.
Financial performance
Amounts are in millions of U.S. dollars, except per-share data and percentages.
| Metric | Q3 2012 | Q3 2011 | 9M 2012 | 9M 2011 |
|---|---|---|---|---|
| Revenue | $136.3 | $116.4 | $382.5 | $312.7 |
| Gross profit / margin | $98.5 / 72.3% | $85.3 / 73.3% | $276.5 / 72.3% | $231.6 / 74.1% |
| Operating income / margin | $25.8 / 18.9% | $26.2 / 22.5% | $65.4 / 17.1% | $62.4 / 20.0% |
| Net income | $17.2 | $17.9 | $45.3 | $46.0 |
| Diluted EPS | $0.10 | $0.11 | $0.27 | $0.28 |
| Operating cash flow | $40.8 | $36.0 | $133.6 | $110.3 |
| Free cash flow, non-GAAP | $24.3 | $34.7 | Not stated in the key-metrics table | Not stated in the key-metrics table |
- Q3 revenue mix: Product revenue was $63.0 million, up 19%; services revenue was $69.8 million, up 21%; ratable and other revenue was $3.5 million, down 37%. Nine-month product and services revenue rose 27% and 24%, respectively.
- Balance sheet and liquidity: At September 30, cash and cash equivalents were $75.5 million, investments were $614.8 million, and combined cash, cash equivalents and investments were $690.3 million, up from $538.7 million at December 31, 2011. Working capital was $216.0 million, versus $256.7 million. Deferred revenue totaled $340.1 million, including $230.6 million current.
- Debt: The balance sheet presents no debt line item. Contractual obligations include $0.1 million of capital leases. The filing says management expects available cash and operating cash flow to cover anticipated needs for at least 12 months.
- Cash flow: Nine-month investing activities used $175.5 million, including net investment purchases and $20.3 million of property and equipment purchases. Financing activities provided $45.6 million, mainly from employee stock-plan share issuance and related tax benefits.
- Margins and costs: Q3 gross margin fell 1.0 percentage point year over year, chiefly from lower services margins; nine-month gross margin fell 1.8 points, reflecting declines in both product and services margins. Operating expenses rose 23% in Q3 and 25% for the nine months. Stock-based compensation was $8.8 million in Q3 and $23.9 million for the nine months.
Material changes and management commentary
- Revenue grew across all three reported regions. Management attributed growth to product innovation, sales execution, and stronger enterprise and service-provider demand. Q3 deals above $100,000 increased to 168 from 130; deals above $250,000 rose to 61 from 39.
- Product unit volumes increased, while average selling prices were slightly lower due to a greater mix of entry-level products. Services growth reflected recognition of revenue from a larger base of subscription and support contracts.
- Management cited higher support-team investment and a larger mix of lower-margin consulting work as pressures on services margins. Higher material costs associated with FortiOS 5.0 also weighed on product margins; management expected those product cost increases to be temporary.
- Headcount increased to 1,854 from 1,527 a year earlier. The company planned continued investment in research and development and sales, while expecting R&D and sales and marketing expenses as a percentage of revenue to remain comparable or decline during the rest of fiscal 2012; G&A as a percentage was expected to remain comparable or decline slightly.
- Management’s stated annual tax-rate planning assumption was 34%, subject to quarterly discrete items. The nine-month effective tax rate was 34%, compared with 29% a year earlier, primarily reflecting expiration of the U.S. federal research tax credit and reduced transfer-pricing-related benefits.
- Q3 billings, a company-defined non-GAAP measure of revenue plus the change in deferred revenue, were $145.0 million, up from $118.4 million. Deferred revenue increased $8.7 million during the quarter. Q3 free cash flow was lower year over year, principally alongside higher capital expenditures, including the Sunnyvale property purchase.
Outlook, risks and unusual items
- The filing gives no specific revenue or earnings guidance. Management cautions that quarterly results can vary and says they are not necessarily indicative of future periods.
- After quarter-end, Fortinet announced FortiOS 5.0, with more than 150 new features, and its FortiASIC-SoC2 processor, which management said provides more than twice the general processing capacity of its predecessor.
- Unusual items include a $1.0 million accrual for a stockholder lawsuit settlement, included in a broader litigation expense discussion; patent-sale revenue of $1.8 million in Q3 versus $2.6 million a year earlier; and the $14.5 million purchase of Sunnyvale land and a building. The filing also reports a $749,000 cash payment related to the IntruGuard acquisition.
- Pending legal matters include patent disputes involving ESR, Network Protection Sciences and SRI International, and a former-stockholder class action. The company accrued approximately $1.0 million for the latter and said settlement discussions had progressed. It stated that it did not then consider losses reasonably possible in the ESR, NPS or SRI matters.
- Key disclosed risks include unpredictable quarterly demand and end-of-quarter order concentration; reliance on channel partners and subscription/support renewals; inventory and component-supply constraints; competition and pricing pressure; product defects or security failures; foreign-exchange exposure; and dependence on third-party manufacturers. One distributor represented 10% of Q3 revenue and 11% of nine-month revenue.
- Unrecognized tax benefits were $25.2 million, with approximately $1.5 million of accrued interest; the filing also reports $26.7 million of tax liabilities, including interest, for uncertain tax positions and says timing of potential cash outflows cannot be estimated. Former CFO Ken Goldman resigned in October 2012; Nancy Bush was interim CFO at filing.
Important facts for investors to verify
- Whether revenue growth and deferred-revenue/billings trends continue, including renewal rates and the distributor concentration.
- Whether gross-margin pressure—particularly in services and from product costs—stabilizes as management expected.
- How continued hiring, stock-based compensation and sales/R&D investment affect operating leverage and diluted share count.
- Whether reported operating cash flow remains supported by deferred revenue and tax-payment timing, and how investment and capital spending evolve.
- Developments in the stockholder settlement, patent litigation and uncertain tax positions, as well as the CFO transition and execution of new product launches.